Is Wesfarmers (WES) a safehaven in troubled times?

Wesfarmers has for years defied contemporary business logic by continuing to perform as one of the world’s most profitable conglomerates.  Decades ago, the idea of individual companies diversifying their income streams by acquiring unrelated companies was in favor.  In a rush to get in on the game, many large corporations went on acquisition binges.  Like drunken sailors, they bought companies even when the competitive scramble drove up the prices of those acquisitions substantially.  Once it became apparent conglomerates were becoming unwieldy dinosaurs, the opposite trend emerged.  Companies were bought and broken up into pieces to sell off.

Despite the historical failure of conglomerates, the idea of purchasing shares in a highly diversified company as a hedge against economic uncertainty still has merit.  Wesfarmers now has the enviable reputation of being one of the world’s most successful conglomerates.  Why?

An Internet search for some information on the history and failure of conglomerates points to an answer.  Wesfarmers stated purpose is to provide a satisfactory return to shareholders.  Their historical approach to acquisitions has been to seek businesses with sound financials, regardless of the nature of the business.  As a corporation, they look for 17% return on equity.  To fit that financial model, operating segments need to yield an average return on capital of 18%.  If they fall to 16% or below, they are sold or shut down if their performance doesn’t improve.  It sounds simple, but according to Wesfarmers executives, that is their secret.

In a time when retailers are increasingly looking for safe-haven investments to weather the potential rough seas ahead, does Wesfarmers qualify?

In last weeks Broker Buys column on thebull.com, we saw four analysts who answer in the affirmative.  Here are some highlights of what they had to say:

•    In more upbeat economic times, Wesfarmers would command a premium multiple due to its strong cash flows from multiple business segments

•    As a conglomerate with many business units, it has the advantage of diversification and these temporary setbacks are a bump in the road on what is a core portfolio holding

•    The company’s strength lays in multiple income sources.  While Woolworths has an enviable track record of well above average earnings per share and dividend growth, Wesfarmers appears to be a potentially stronger growth story.

•    The success of industrial conglomerate Wesfarmers can be attributed to a diverse range of businesses with strong positions in their markets. The largest contributors are supermarket retailing, hardware and coal.  Diverse revenue sources smooth the earnings stream.

All these analysts are bullish on WES because of the company’s base of diversified businesses.  Visit the company’s website to view their financial statements and you will see they have eight independent operating units:

1.    Coles (Supermarket Retailing)

2.    Home Improvement and Office Supply (Bunnings and Office Works)

3.    Target

4.    K-Mart

5.    Resources (Curragh, Premier Coal)

6.    Insurance

7.    Chemicals, Energy, and Fertiliser

8.    Industrial and Safety

Australia’s other giant retailer, Woolworth’s (WOW), is not as diversified, yet they have performed well.  Here is a comparison of Net Profit after Taxes (NPAT) for both Woolworths and Wesfarmers over the last five years:

In that five year period, Woolworth doubled its NPAT and Wesfarmers was not far behind.  Both companies pay dividends and Woolworth has an impressive 10 year dividend growth rate of 17.5% while Wesfarmer’s 10 year dividend growth rate was 5%.

Based strictly on these numbers, WOW appears a strong investment as well.  However, these numbers are “looking in the rear view mirror” as they represent past performance.  How do share market participants view the future of these two companies?  Here are some key market valuation ratios:

While Wesfarmer’s P/E is slightly above the Sector average, the PEG and the P/B suggest the company’s shares may actually be undervalued.  They do indicate share market participants expect greater growth from Wesfarmers than from Woolworths.

Executives at Woolworths agree regarding their own prospects.  As indicated in the Broker Buys column, in January 2011 Woolworths lowered its forecast for 2011 – the first time the company has done so in 20 years.

Economic conditions in Australia are softening.  Some argue this is no more than a blip on the radar while others predict a real downturn.  There is no argument that property prices are under pressure, household debt is high, and consumer spending is down.  In addition, commodity prices are under pressure as well.  

Wesfarmers recently agreed to reduce its contract price for metallurgical coal from its Curragh mining operation by 10%, leading to a decline in share price.  

Given these uncertain conditions, should retail investors look to buy WES on the decline or stay on the sidelines?

As you know, even in the depths of the GFC (Great Financial Crisis), consumers still lived their lives and businesses continued to operate.  Both businesses and consumers, however, are more careful in a downturn about where they spend and increasingly look for better value in what they buy.  How would WES stand up in the event of a real downturn?

To consider that question, let us take a look at exactly from where their profit comes right now.  Just how well-diversified are they?  Checking their financial reports, we constructed the following table that looks at the contributions made by each operating segment.  We will look at the Earnings before Interest and Taxes (EBIT) for each segment as well as the percentage contribution of EBIT towards total earnings and also revenue generated.  Here are the numbers:

First, note that the Resources segment, which includes the company’s coal operations, contributes 8% to earnings before interest and taxes.  The major contributor to EBIT is Coles – a supermarket operation that already offers competitive pricing to consumers.  

If you take a moment to review the company’s websites and other Internet sources, you will learn Coles appears to be pressuring Woolworths to lower its margins in its own supermarket operations.  The “milk wars” are a case in point.

Getting back to the numbers, a full 79% of Wesfarmers earnings before interest and taxes come from its four retailing segments.  However, all these segments offer consumer staples.

No one can predict with any accuracy a percentage drop in demand within these segments.  Even in the toughest of times, businesses still need supplies; everyone still needs coal-generated electricity; people still need to buy things to maintain their homes; and everyone still needs to eat and clothe themselves.

No share market investment is ever totally safe.  If you dig further into the makeup of each of Wesfarmer’s operating segments, you could make a solid case for their ability to weather any economic storm.

>>Back to the newsletter to view other articles – July 16th 2011

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